However, the spotlight belonged to the broader market, where the BSE Midcap and Smallcap indices surged by 25% and 30%, respectively.
Individual stocks often outperformed the indices, with notable gainers and losers emerging across the Nifty, BSE Midcap, and BSE Smallcap segments. While some sectors and stocks delivered exceptional returns, the overall trend remained upward, with most stocks either gaining or avoiding significant losses.
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That said, there were exceptions. A few stocks faced sharp declines, primarily due to stock- or sector-specific issues rather than any overarching market sentiment shift.
As we look ahead to 2025, questions linger: Could market sentiment turn negative, reversing the uptrend? Or will the indices, alongside the broader market, continue their climb to new highs?
Liquidity and risks
The primary driver behind the bullish 2024 market was robust liquidity, fuelled by retail investors and high-net-worth individuals (HNIs) through direct investments, mutual funds, portfolio management services, and family offices.
This influx of funds sustained high valuations throughout the year, even as corporate earnings growth slowed.
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The Nifty’s price-to-earnings (PE) ratio, a key indicator of market valuation, has remained above 20 throughout 2024. Historically, a PE above 25 signals overvaluation. As of the year-end, the Nifty’s PE stands at around 22.
The broader market, however, is even more expensive. Retail investors and high-net-worth individuals (HNIs) have shown a strong preference for midcaps and smallcaps in 2024, driving valuations higher in these segments compared to largecaps.
One metric that illustrates this disparity is the Smallcap-to-Sensex ratio, a measure of the relative valuation of smallcaps against largecaps. This ratio, often cited by Richa Agarwal, Equitymaster’s smallcap editor, indicates overvaluation when it exceeds the long-term median of 0.45. For instance, in January 2018, when the smallcap index peaked, the ratio was 0.58, and the smallcap index subsequently fell 40%.
Currently, the ratio is at a striking 0.7, significantly above its historical benchmark. Yet, the combined earnings of all smallcap index companies amount to only 36% of the total earnings of Sensex companies.
This disparity highlights the risk in smallcap stocks, as investors are paying steep prices for future earnings that may not materialize. If these companies fail to meet earnings expectations, a severe correction is likely.
So far, however, the broader market has largely avoided such corrections. The number of midcap and smallcap stocks down by 20% or more remains limited compared to the overall market. Interestingly, largecaps have underperformed in this regard, reflecting a more cautious sentiment in the Nifty segment.
Outlook for 2025
Compared to the broader market of midcaps and smallcaps, the Nifty and largecaps, in general, are not yet in overvalued territory. This leaves room for potential gains in the index in 2025.
However, this is no reason for complacency.
A mere 15% rise in the Nifty from its end-2024 levels could push it into overvalued territory, particularly given the lack of support from corporate earnings growth. Historically, robust earnings growth has provided a cushion for high valuations, but the current outlook is less optimistic.
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GDP growth has slowed, and with urban consumption facing significant headwinds, a swift recovery appears unlikely. As a result, 2025 could witness moderate GDP growth without much acceleration, which would cap the profit growth of large companies.
While we do not rule out further gains in the Nifty, driven by positive sentiment and the potential return of foreign institutional investors (FIIs), such a rally could leave the market dangerously overvalued. Any remaining pockets of undervaluation might quickly disappear.
Although our long-term outlook for the Indian stock market remains bullish, we must acknowledge the risks building up in 2025, particularly in midcaps and smallcaps. A cautious approach is warranted.
What should investors do in this market?
If you’re a long-term investor holding fundamentally strong stocks purchased at reasonable valuations, there’s no immediate action required. You’re well-positioned to build wealth over time. If these stocks experience a correction, consider using the opportunity to add to your positions.
However, it’s crucial to periodically review your portfolio. Identify stocks that may have become significantly overvalued or those where the company’s fundamentals have deteriorated. Additionally, re-evaluate any holdings where the original investment thesis is no longer valid. Such cases may warrant a reassessment of your position.
For investors with a shorter holding period—say, less than three years—there’s greater cause for caution. In the event of a market correction, some stocks in your portfolio may struggle to recover quickly. This risk is heightened for stocks facing weak earnings, corporate governance issues, or sudden management strategy shifts.
To mitigate these risks, examine your portfolio now for signs of weakness in revenue, profit, or margins. Stay vigilant for any abrupt changes in management strategy, as these could further erode market confidence. Stocks with such vulnerabilities may face significant declines if market sentiment turns negative or if broader trends amplify these concerns.
Preparedness and proactive portfolio management are key in navigating potential market challenges.
Conclusion
When the stock market is on the rise while underlying earnings growth slows, it’s a signal for investors to exercise caution.
This doesn’t mean reacting with panic selling during a market dip. Instead, it calls for a highly selective approach when choosing stocks, especially in the midcap and smallcap segments.
Maintain a vigilant eye on your portfolio, watching for signs of weakening fundamentals or overvaluation. Regular assessments can help you stay ahead of potential risks.
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In the long term, the Indian stock market is poised to grow in tandem with the economy. However, in the short term, there are enough reasons to approach the market with prudence.
Happy investing.
Disclaimer: This article is for education purposes only. It is not a recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com